Everyone Is Misreading Reinhart And Rogoff

If the rallying cry for deficit reduction rests on an intellectual framework, it would be the work of Carmen Reinhart and Ken Rogoff, whose book, This Time is Different, has been hailed for its exhaustive historical study of financial crises. A key finding of those scholars - that economic growth slows once the ratio of debt-to-GDP exceeds 90% - has been widely cited by those calling for decreased government spending.

But those calling for deficit reduction have largely ignored a number of caveats that Reinhart and Rogoff gave with respect to their 90% threshold, and as a result many warn that the US faces the imminent danger of a Greek-like sovereign-debt crisis.

Take, for example, PIMCO's Bill Gross, who wrote the following on October 31 of last year:

The situation, of course, is compounded now by high debt levels and government spending that always used to restart capitalism's private engine. However, as economists Rogoff & Reinhart have shown in their historic text, This Time Is Different, sovereign debt at 80-90% of GDP acts as a barrier to growth.

First of all, Reinhart and Rogoff did not write about the 90% threshold in This Time is Different; they published research about that threshold only after the book was written, in two separate articles (found here and here).

The more important problem with the claims that Gross and others have made about the 90% threshold is that they ignored Reinhart's and Rogoff's own words of caution with respect to the special situation of the US, and they failed to consider the limits inherent in Reinhart and Rogoff's dataset of countries with high debt levels.

I spoke with Rogoff last week, and he explained that one of those limitations is the rarity of such high-debt events and the extreme rarity of examples of countries exceeding 120% of debt-to-GDP.

Rogoff did not comment on how others have interpreted his research, but I will. I will explain its limitations and caveats, and then turn to the decisions policymakers should make in the context of our growing fiscal deficit.

What Reinhart and Rogoff did and did not say

Let's look at what Reinhart and Rogoff said in the two papers cited above. Using the same data that they used in This Time is Different, which consisted of observations from 44 countries over the last two centuries, they found that there was very little relationship between economic growth (as measured by GDP) and public (government) debt, for debt levels below 90% of GDP.

For advanced economies, however, Reinhardt and Rogoff found that once debt exceeds 90% of GDP, median growth slows by roughly 1% annually. The data for advanced economies consisted of 1,186 annual observations, of which 96 were from countries with debt-to-GDP greater than 90%; most of those observations came in the immediate wake of World War II.

They also studied a smaller dataset of emerging markets, which incorporated both public and private debt. For those countries, growth slows even more drastically once total debt exceeds 60% of GDP. In addition, they studied the relationship between debt and inflation. But I will focus on the relationship between debt and GDP for developed economies, since that has the most direct implications for the US.

Reinhart and Rogoff stated that countries seldom grow their way out of debt. Many countries have approached a "debt intolerance" boundary, at which point "market interest rates rise quite suddenly, forcing painful adjustment," they wrote.

It is this last point that has drawn the most attention. Many have interpreted this to mean that the 90% threshold is a barrier, above which growth slows, bond markets revolt and interest rates surge. For example, here is a comment Liz Ann Sonders of Charles Schwab made in April of last year:

We are about to cross a very important threshold where public debt becomes greater than 90% of GDP. That will happen this year. Reinhart and Rogoff have shown very clearly that, over the last several hundred years, that is an important threshold for the ability of economy to grow.

In a report published last week, the Boston Consulting Group made a nearly identical statement, and John Mauldin has used the 90% threshold to bolster his claim that we are at the end of a global "debt supercycle."

In a Business Week article on July 14 of last year, Reinhart and Rogoff addressed this point:

We aren't suggesting there is a bright red line at 90 percent; our results don't imply that 89 percent is a safe debt level, or that 91 percent is necessarily catastrophic. Anyone familiar with doing empirical research understands that vulnerability to crises and anemic growth seldom depends on a single factor such as public debt. However, our study of crises shows that public obligations are often hidden and significantly larger than official figures suggest.

Rogoff confirmed this when I spoke with him. "90% is not an arbitrary number in this sense. It's rare to get above it, and above 120% is exceedingly rare," he said.

Reinhart and Rogoff also distinguish between two independent debt levels: One when grow slows (90% of GDP) and a second unspecified "intolerance" level, when bond markets force interest rates higher and solvency is threatened. Many commentators (and perhaps the S&P ratings agency) fail recognize this distinction, and wrongly conclude that the US faces the threat of insolvency. Japan, with debt-to-GDP of over 200%, clearly illustrates that the bond markets can tolerate slow growth well beyond the 90% threshold.

Any notion that 90% is a hard barrier imminently endangering the US economy is not supported by the authors' research.